ESSA

ESSA

E-con? Economics and Irrationality


Jesse Condie

By

April 6th, 2015


Economic models of old can’t explain why anyone would buy a lottery ticket. But using behavioural economics, we might one day be able to fully model human behaviour, writes Jesse Condie.


I was working, alone and bored, on a pretty quiet Thursday last week. As anyone familiar with behavioural economics would know, there isn’t much of an incentive for me to work harder than adequate if I’m being paid hourly. My boss knows this, and he knows he’s not getting the most out of the resources he uses to pay his lazy employee – but still he keeps me hired. Customers can act just as irrationally. People who choose to buy our wares are sometimes blatant chocolate lovers, but they end up choosing vanilla because a friend suggested it, tampering with their own well-defined preferences.

As you can see, irrationality is everywhere. Countless economic theories come into play whenever economic agents interact with each other. But decisions made are often contrary to those our models predict. Humans are definitely not the ‘Econs’ that models assume – and indeed, this is one of the biggest criticisms being made on a daily basis by those disillusioned with the value of economics. However, new schools of thought in the field of behavioural economics are gradually uncovering and cleaning the empirical data explaining these decisions, in the hope that one day we can conceivably model human nature. Inspired by that work, I’ll take a look at one major economic choice that is irrational for almost anyone, yet swings a large proportion of ordinary people to do it anyway: buying a lottery ticket.

It won’t surprise you that a non-negligible proportion of the elderly and working class population have a compulsive lottery habit. It hardly seems a rational one. To be given a 1 in 8,145,060 chance of winning Division 1, for which there is an average lottery prize of $1.7m each week, is pretty unattractive to begin with. Now assume that the average Tattslotto citizen buys the Super QuickPick ($12.80 for 18 picks). This gives them an 18 in 8,145,060 chance of winning Division One per week. If, like many lottery players out there, they get a ticket every week for the next 20 years of their working/retired life, accounting for opportunity cost lost by not investing the money in the current 4% return (also unchanged for simplicity’s sake), then it would cost them $20,385.20 (or $9,162.46 in present value terms) to keep this habit!

That’s a lot of numbers, but the short of it is that some people are willing to pay $9,162.46 to get an (18/8,145,060)*1040 (very small!) chance of winning an average $1.7m lotto even once. Converted to fractions, the lottery is starkly unfair – would you be willing today to pay $9,162.46 to enter a lottery that gives you a less than 1 in 400 chance of winning $1.7m? Even a risk lover would hesitate at this incredibly unfair lottery. Yet even if you presented these numbers to an elderly relative who has been buying Tatts tickets for years, they’d most probably carry on buying them anyway.

But why? What explains the swap in revealed preferences that is impossible to explain in preference utility functions? Behavioural economics suggests many possible answers, most notably a cognitive quirk that gives lottery participants ‘utility’ for just thinking about winning! This is most certainly irrational from an old-fashioned economic viewpoint, but newer utility functions can explain this preference reversal and utility derived from external factors.

The classical ‘econs’ that form the basis of our models are notably different from humans. This is obvious when we make decisions that don’t make economic sense, like buying lottery tickets. We are seeing new ways to explain irrational human behaviour, however, and I hope one day we progress to a point where the study of Econs is rational, because we have found a way to map their behaviour in a way that accurately reflects our own. With the progression of technology in the past twenty years giving us access to a huge economic toolbox, there may be a point in time where modelled Econs truly represent human nature.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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